Difficult times for Cameron and Osborne

But elsewhere in Europe, it's even worseDespite UK weakness, sterling may benefit from haven flows

by David Marsh

Mon 18 Mar 2013

Difficult times for David Cameron, the UK prime minister, and his embattled chancellor of the exchequer, George Osborne. Their only consolidation: everywhere else in Europe, it's even worse.

Cameron faces a potential Conservative party leadership challenge amid persistent doubts over the quality of his premiership and the strength of his shallow marriage-of-convenience coalition with the Liberal Democrats.

In his annual set-piece budgetary statement in parliament on Wednesday, Osborne will admit that growth will be lower and government debts higher than expected this year. But he will reiterate that the government must persevere with austerity to maintain international financial credibility. For the time being, at least.

The one reasonably sure aspect on financial markets is that the dollar should perform well in coming months. The greenback is buoyed by better US economic prospects and a growing realisation that US banks are in far better shape than their European counterparts.

Sterling seems likely therefore to come under further pressure against the dollar compared with present values around $1.51. But it cannot be ruled out – despite the poor state of the British economy – that sterling will benefit from 'haven-seeking' inflows as the euro area faces another set of disturbances.

The seven-and-a-half month period of calm induced by the announcement of the European Central Bank's untried Outright Monetary Transactions (OMT) bond-buying scheme has now ended. The inconclusive Italian election, the weekend’s messy aid package for Cyprus, divergences with the Greek government over official aid for Athens, doubts about French economic policy and pre-election storm clouds in Germany have put paid to all that. The odds must be shortening that the OMT will never be used.

You might think that the run on Cypriot deposits would be a harbinger of worries about deposit safety among savers in Spain, Greece and so on. You would be right. But what's worse: these anxieties are becoming even stronger in Germany.

Remember: that's where they do angst best. That's where you find the most important concentration of savings in Europe. And that's the place the politicians would raid if they really wanted the money.

One sign of stirring economic anxieties in the UK is an extraordinary U-turn on the sterling exchange rate by Bank of England governor Sir Mervyn King. Last year, as international funds surged into the UK amid heightened worries over the euro, King said sterling’s rise was 'not a welcome development' and implicitly called for the pound to weaken.

This year, sterling has lost almost 6% of its trade-weighted value. But at the end of last week King waded into the currency markets again when he said the pound was now 'properly valued'. The remarks reversed, at least temporarily, a wave of sterling selling brought about by Cameron’s political problems, Moody’s downgrading of the UK‘s triple A credit rating and the country’s weakest recovery from recession for the past 100 years.

Meanwhile a battle is looming among Osborne’s supporters and denigrators on the wisdom of continuing the government’s austerity policies aimed at reducing public debt. The irony of the government’s position is that the public sector debt is still 8% of national income, well above that of hard-pressed members of the euro area regularly denigrated for economic incompetence by the UK government.

Britain’s economic plight has increased expectations that Bank of Canada governor Mark Carney, who succeeds King as BoE governor at the end of June, will launch even looser monetary policy to boost growth – a big factor behind the recent sterling fall. King’s latest comments seemed at variance with minutes of the BoE’s latest Monetary Policy Committee meeting. These showed that King shifted in favour of more quantitative easing, which would have the effect of weakening sterling.

With tensions rising in Cameron’s coalition with the increasingly fractious Liberal Democrat party, speculation is increasing about changes in the Conservatives’ line-up ahead of the next election in 2015.

Conservative British prime ministers have a long tradition of playing musical chairs with their chancellors in reaction to political setbacks. This happened three times during Harold Macmillan’s almost seven years as prime minister (1957-63). Margaret Thatcher moved Sir Geoffrey Howe (chancellor 1979-83) to the Foreign Office after the 1983 election. She and Nigel Lawson (chancellor 1983-89) fell out over exchange rate policy, and Lawson resigned. His successor John Major became prime minister after a year at the Treasury, when the Conservative Party got rid of Thatcher.

Then, at a short interval after the Black Wednesday fiasco when the UK left the exchange rate mechanism in 1992, Major sacked chancellor Norman Lamont the following spring.

An example of what could happen to Osborne comes from an episode in 1967, under Labour prime minister Harold Wilson, when James Callaghan, who was chancellor from 1964-67, swapped jobs with Home Secretary Roy Jenkins in the wake of the pound’s devaluation. An optimal way of shifting Osborne while maintaining his dignity would be to arrange for him to swap jobs with William Hague, the present foreign secretary – even though the latter would resist such a move. Depending on how growth and sterling perform this year, Cameron’s political juggling will face increasing scrutiny as 2013 wears on.